Simplifying the Social Security Debate

The Social Security debate contains enough policy jargon to make a PHD in political science choke. Can we afford the Social Security transition costs? What is this debate about wage-indexing versus price-indexing? Does the retirement age need to be raised? Is it wise to let workers gamble with their retirement futures? These are the questions that this post will try to answer. And I'll try to keep my answers in English, not Congressional Budget Office mumbo-jumbo. Bear with me here.

Can We afford the Social Security transition costs?

There is nothing in the Social Security reform rule book that says that there has to be such transition costs. I'll provide an extreme reform proposal to illustrate my point. A 16 year old is going to begin working at a fast food restaurant next month. Currently, workers pay 12.4 percent of their pay into the Social Security trust fund, 6.2 percent is from the worker's paycheck and an additional 6.2 percent is from the employer.

But my Social Security reform is going to be in place before our hypothetical 16 year old (let's call him "John Young" from now on) starts his first day on the job. John Young isn't going to pay 12.4 percent of his wages (again, including both employee and employer "contributions") into the Social Security trust fund. Instead, that 12.4 percent is going to be deposited into John Young's personal retirement account. But in exchange for not having to contribute to the Social Security trust fund, John Young is not going to be entitled to any traditional Social Security benefits when he reaches retirement age. The result? John Young pays nothing to the government for the purpose of funding his retirement and John Young doesn't receive any money from the government when he retires. As far as the federal government is concerned, it's a wash and the transition costs are zero.

There is no transition cost over John Young's entire lifetime, including both his working years and his retirement years. And my example assumes that John Young's traditional Social Security benefits would be eliminated. So, there are three points I hope you will take away from this example:

(1) If today's workers are allowed to contribute to personal retirement accounts instead of the Social Security trust fund, their traditional Social Security benefits must be cut in proportion to the share of the 12.4 percent of payroll that is diverted to these personal accounts. (In my example, 100 percent of the 12.4 percent payroll "contribution" was sent to personal accounts and traditional benefits were cut by 100 percent. President Bush said in his State of the Union address that he would allow up to 4 percent of payroll to be diverted into personal accounts. That's (4 divided by 12.4) 32.26 percent, which would require a 32.26 percent cut in traditional benefits.

(2) If the requirements of point number (1) is followed, long term transition costs are zero.

(3) If the requirements of point number (1) is followed, the Social Security trust fund is just as insolvent as under the current system.

Solvency

Solvency: Isn't that what reforming the Social Security system is supposed to be all about? Yes. And the debate over personal accounts doesn't directly deal with the solvency issue. It's about time we dealt with the solvency issue then.

When someone says that the Social Security system is insolvent what do they mean? They mean that the Social Security system, if unchanged, will pay out more in benefits than it receives in "contributions" by 2018 and will exhaust the trust fund by 2042. What this really means is that the current system over promises benefits to current and future Social Security retirees based on the current level of taxation (12.4 percent of payroll).

What is this debate about wage-indexing versus price-indexing?

Glad you asked. You might have heard some intelligent sounding person say the following: "If the economy grows fast enough, the current Social Security system will turn out to be just fine and no adjustments will be needed."

That's complete bunk. And it's because of something called "wage-indexing." Wages tend to rise at the rate the economy grows. And under the current system, Social Security contributions are wage-indexed. This means that if I paid $3,000 dollars into the Social Security trust fund back in 1990, the Social Security system will give me credit for having contributed much more than $3,000 because the average wage has increased since 1990. For example, $3,000 contributed in payroll taxes in the year 1990 is equivalent to $4,587 contributed in the year 2000. So, a strong economy doesn't solve the solvency problems of Social Security because a stronger economy leads to larger increases in wages and larger increases in wages cause larger increases in traditional Social Security benefits as a result of wage indexing. For more information on wage-indexing visit this Social Security web page.

If we changed the law so that traditional Social Security benefits were calculated using the Consumer Price Index (CPI) index of a wage-index, this would solve a significant portion of the Social Security solvency issue. Under price-indexing, if the economy were to grow faster than inflation (the CPI), Social Security revenues would be allowed to grow faster than traditional Social Security payments.

Does the retirement age need to be raised?

That's another way to solve the solvency issue. The Social Security system originated at a time when people didn't live as long. Like shifting from wage-indexing to price-indexing, raising the retirement age is another way of reducing benefits and, thus, a means of improving the solvency of the system.

Is it wise to let workers gamble with their retirement futures?

That's really a philosophical issue. An extreme libertarian, like me, might say, "Certainly. People should be allowed to do what they want with their own money." But most Social Security proposals don't allow people to invest their personal account money in race horses, art paintings or soggy real estate. Most proposals won't even let you invest 100 percent of your portfolio in a single corporation. Instead, you must invest in a diversified fund and you must dollar cost average (which means you buy shares of a fund every pay day).

A few concluding points

If you haven't already fallen asleep and hit your head on the computer monitor, I would like to point out a few more things.

The Social Security debate results in people talking about "cuts" in a misleading way. I, being 38 years old, can look at my latest Social Security statement and notice that I am being promised $1,500 per month when I reach age 67. Anyone familiar with the state of the current Social Security system's financial structure knows that this $1,500 figure is unaffordable.

If, as a result of a reform in Social Security, I end up receiving $900 per month when I turn 67 years old, is that really a "cut?" In my opinion, it's as though you promised your son when he was 14 years old that you would send him to Harvard, but a few years later, because of financial considerations, you tell your son that you can only afford to send him to the local State University. If you hadn't promised your son that you would pay a nickel towards his college education in the first place, funding his state University expenses would not have been viewed as a "cut."

Most reform proposals exclude people aged 55 years or older from any changes in their benefits. This seems fair (I'm 38, by the way) since these folks have less time to adjust their investment and work plans in response to changes in the law.

Update: Cato's Social Security Ideas

Visit the Cato Institute's web page on Social Security reform for many interesting columns on this issue.

Update: Delaware's former Governor, Pete Du Pont weighs in

Here's a column about Social Security by Pete Du Pont. I think he has hit the nail on the head.

Why do Dems oppose Social Security reform? Because they're committed to government control.

In 1945 Clement Attlee led the British Labour Party to victory over Winston Churchill's Conservative Party. He then proceeded to socialize much of the British economy, for he believed that "the creation of a society based on social justice . . . could only be attained by bringing under public ownership and control the main factors in the economic system." Labour's goal was to get rid of the waste and irrationality that, in the socialist view, doomed market economies to failure.

Fast forward six decades, and you hear an Attlee echo--Sen. Hillary Clinton telling a California audience last summer that taxes must rise because "We're going to take things away from you on behalf of the common good."

American socialist Noam Chomsky made the same argument concerning Social Security: that allowing people to invest in markets is a bad thing, for "putting people in charge of their own assets breaks down the solidarity that comes from doing something together, and diminishes the sense that people have responsibility for each other."

So the 2005 Social Security argument is an old and familiar one: government decisions versus individual ones, government control of assets versus individual ownership. In short, socialism versus individualism.

Update: Nick Schulz remembers FDR better than Al Franken

Shortly after President Bush's State of the Union address New York Times columnist Paul Krugman accused President Bush of trying to "destroy" the America created by FDR by introducing private accounts into the Social Security system. I wrote a column at the time claiming Krugman was wrong and that, based on some principles FDR outlined in a message to Congress when Social Security was being constructed, one could reasonably conclude that Bush's effort was in keeping with the principles outlined by FDR.

So what did FDR say? Let's look again at the quote:

"In the important field of security for our old people, it seems necessary to adopt three principles: First, noncontributory old-age pensions for those who are now too old to build up their own insurance. It is, of course, clear that for perhaps 30 years to come funds will have to be provided by the States and the Federal Government to meet these pensions. Second, compulsory contributory annuities that in time will establish a self-supporting system for those now young and for future generations. Third, voluntary contributory annuities by which individual initiative can increase the annual amounts received in old age. It is proposed that the Federal Government assume one-half of the cost of the old-age pension plan, which ought ultimately to be supplanted by self-supporting annuity plans."